Did the January Effect Arrive Early?

December-January is a sweet spot for small-cap ETF traders

“There is an appointed time for everything,” are the famed words from Ecclesiastes 3:1. This eternal truth is applicable even to the stock market, which like the rest of nature, has its times and seasons.

Among these “times and seasons” is the “January Effect.” It runs from mid-December to the end of February and it’s the historical tendency of small cap stocks (VB) to outperform their large cap counterparts. (Small caps are generally classified as companies with a market size of less than $3 billion.)

Over the past five years, small cap stocks have indeed outperformed large caps four out of five times and thus far in 2013, small caps are poised to echo that same feat. The chart below shows how the Russell 2000 small cap ETF (IWM) has beaten the SPDR S&P 500 (SPY) by a margin of 1.2% over the past month.

Interestingly, the relative strength and outperformance of small caps vs. large caps actually began in mid-November, which means we could say the January Effect started earlier this year than normal. IWM, like other small cap ETFs, is in an uptrend and trades above its 20, 50, and 200 day moving averages.

The period from Dec. 15-Jan. 31 has been the sweet spot for January Effect traders, with an average gain of 4.8% vs. just a 2.8% gain for large cap stocks (DIA) since 1979, according to the Stock Market Almanac.

One of the known factors driving the January Effect is the behavior of institutional investors, otherwise known as the “big money.” At the beginning of the new year, the “big money” searches for and adds higher risk small caps along with microcaps (IWC) to their portfolios in an attempt to position themselves for market outperformance. They’ve got billions of dollars under management and they don’t want to be seen as index huggers.

Although market theorists like Nassim Nicholas Taleb decry stock market patterns like the January Effect as completely coincidental and random, the behavior of stock market participants to act a certain way and at a certain time toward small caps is hardly a fluke. Here’s one way to think about it: We are all creatures of habit, so the stock market can be viewed, in a sense, as a mere reflection of our human selves or tendencies.

Overweighting small caps vs. large caps in line with the “January Effect” won’t always be a profitable trade, but when it does, there’s money to be made.

The ETF Profit Strategy Newsletter uses technical, fundamental, and sentiment analysis along with market history and common sense to keep investors on the right side of the market. Since the beginning of the year, 74% of our weekly ETF picks have been winners.